Amsterdam School of Economics

The effects of austerity measures on private sector confidence

5 February 2016

Is there a relationship between austerity measures and consumer confidence? And how does a fall in confidence result in a lower consumption? In her PhD, Oana Furtuna researches the expectational effects of fiscal consolidation.

Presently, economist University of Amsterdam Oana Furtuna is working on the second article for her PhD which studies the relationship between consumer confidence and the effects on the real economy. ‘The literature suggests there is such a relationship, namely that confidence may affect future economic growth’, says Furtuna. ‘But there is still more research needed on this topic. We know that consumption falls when certain taxes are increased. And previous work shows that consumer confidence falls after a tax increase. But is there a role for expectations in the transmission mechanism between taxes and consumption?’ Her article will be available online in March or April of 2016.

Furtuna’s first article, ‘The confidence effects of fiscal consolidations’, was published in Economic Policy, 30 (83), in July 2015. She wrote the article as part of her final thesis at the Tinbergen Institute together with UvA professor Roel Beetsma, Jacopo Cimadomo and Massimo Giuliodori. The latter is also a professor at the University of Amsterdam and Furtuna’s supervisor. Furtuna started her PhD in September 2014.

Furtuna was born in Romania where she studied International Economics. After she completed a Master of Science at the UvA, Furtuna started the rigorous two-year research master's programme (MPhil) at the Tinbergen Institute. As a researcher, Furtuna describes herself as ‘not very patient’. ‘I want to see results quickly, which is why I prefer empirical research’. She takes her research very seriously. ‘Economic science is important. One way or another, we are all dependent on the state of the economy.’ Once she finishes her PhD, Furtuna might return to Romania. ‘Romania needs more economists who can work with economic data.’

Austerity and confidence

Her forthcoming article concerns the transmission of fiscal policy announcements to output growth, through the channel of consumer confidence, after her first paper studied the relationship between (the announcement of) fiscal consolidation and consumer and producer confidence. ‘We wrote our article at a time when many Western governments were taking severe austerity measures’, Furtuna says. ‘When we started, it was advocated that austerity is not necessarily recessionary. Some authors claimed that a spending cut by the government doesn’t lead to a drop in output, because of the positive role of expectations. It is assumed that government spending cuts today will have a positive effect on confidence, because everyone expects government debt to fall, and therefore that taxes can be lowered in the future.’

Furtuna and her colleagues questioned these views and tested them. ‘Our overall result is that fiscal consolidation is never positive for confidence. At the same time we found that spending cuts have weaker negative effects than revenue measures, such as increasing taxes.’

The article builds on insights from a strand of literature which suggests that private sector confidence plays a key role in influencing business cycle fluctuations. However, Furtuna and her colleagues thought that there was little emphasis on the quantification of the effect of fiscal measures on consumer confidence. The researchers started a new empirical analysis aimed at investigating how announcements of fiscal consolidations affect consumer and business confidence. They used sets of monthly data for 17 OECD countries over the period 1978-2009.

Tight fiscal rules have positive effect

Overall Furtuna and her team found that consolidation announcements are associated with a reduction in consumer and business confidence. Consumers react more strongly to these announcements than businesses do.

This negative relationship is mostly driven by announcements of revenue based consolidations, such as raising taxes. There is no statistically significant evidence that the reaction of consumer confidence to austerity announcements is worse in slumps than in booms. Other circumstances matter for the dynamics of confidence, having to do with the amount of trust there is in the government. When a government has weak fiscal rules and low transparency, the negative effect on confidence is larger.

Furtuna is reluctant to draw strong policy conclusions, not in the least because she is still working on research on the relationship between confidence and economic growth. But there are some overall insight she can share. ‘If you assume that confidence is important for economic growth, which is the question in my current paper, then governments must do a number of things. First, the government needs to be highly credible. Solid fiscal rules and high transparency can dampen the negative effects of consolidation measures. Furthermore spending cuts seem less negative for confidence than expenditure measures, even during an economic downturn.’

The recent consolidation measures taken by European governments hit the southern countries especially hard – countries which had implemented ambitious fiscal consolidation plans. Furtuna points out that Spain is doing much better recently. ‘The policy in Spain is a success and its economy is growing again. The reform of the labour market is an important contributing factor to the recovery of the Spanish economy. In my view, the combination of fiscal austerity measures with credible structural reform was a successful one.’

The Dutch economy was hit by the housing slump, after prices had risen sharply. ‘There is evidence that in an economic environment with high private debt, the effects of austerity measures on consumption and output could be stronger.’